IMF Paper Examines Impact of Bank Competition on Systemic Risk

ByRegulatory News

IMF published a working paper that examines how bank competition in the run up to the 2007-2009 crisis affects systemic risk of banks during the crisis. It also investigates the extent to which capitalization and securitization affect the relationship between market power and systemic risk, particularly their role in shaping bank incentives to screen and monitor borrowers in the provision of credit. Using a sample of the largest listed banks from 15 countries, it was found that greater market power at the bank level and higher competition at the industry level lead to higher realized systemic risk. The results suggest that the use of securitization exacerbates the effects of market power on the systemic dimension of bank risk, while capitalization partially mitigates its impact.

The paper provides a discussion of the theoretical framework, reviews the relevant literature, and sets out the empirical model, data sources, and identification strategy. It also covers the empirical results, results of robustness tests, and further identification analyses via the separate estimation of non-mortgage and mortgage securitization. The financial crisis has shown that it is necessary to take a more detailed look at how changes to the banking system (such as securitization or enhanced solvency regulations) alter the behavior of banks. The findings suggest that regulators should pay close attention to how these changes interact with competition in banking markets. The finding that capitalization does not fully counterbalance the impact of securitization on the market power-systemic risk relationship implies that capital adequacy requirements might need to be supplemented with additional supervisory tools to strengthen banks’ incentives to screen and monitor their borrowers more intensively.

The results show that bank-specific market power in the pre-crisis period leads to higher systemic risk during the crisis and that a higher level of competition at the industry level is associated with a higher level of bank systemic risk during the crisis. The positive relationship between market power and systemic risk decreases with capitalization but increases with securitization. Furthermore, bank capital does not fully counterbalance the effect of securitization on the relationship between market power and systemic risk. The results are robust to a number of tests, including different measures of systemic risk, competition, and capitalization, as well as to the inclusion of additional bank-specific characteristics and additional estimations using instrumental variables. It can be concluded that banking supervisors and macro-prudential regulators should collaborate closely with competition authorities to prevent the buildup of large systemic risks. The findings also suggest that bank capital alone is not sufficient to offset the adverse impact of competition and securitization on systemic risk of banks. In particular, the higher capital requirements in Basel III may need to be supplemented with additional regulatory tools that can incentivize banks to increase screening and tighten lending standards for certain borrowers to mitigate the creation of systemic risk.